Shorting and Short Squeezing: Wonders of the Stock Market

Shorting means lending shares from a broker with a motive of short selling those shares and making a profit from the difference in the changed value of the share. So how does this take place? Let's understand this with a hypothetical example. There is a company XYZ Ltd. with a share price of ₹100. An investor, NM, borrowed 10 shares of XYZ Ltd. from a broker (which means he spent ₹1000) and promised to return those shares after 24 hours. Then, NM sold those shares (which means he received ₹1000) in the share market and waited for a reduction in the share price of XYZ Ltd.; when the share price of those shares went to ₹60 he purchased 10 shares of XYZ Ltd. from the share market (which means he spent ₹600) and returned those shares the particular broker from whom he borrowed those 10 shares. Therefore, by shorting the stock of XYZ Ltd., NM earned a ₹400 profit - which is the difference between the past and the present value of shares of XYZ Ltd.

Short squeezing, on the other hand, is when an investor repeats the process of shorting but suffers loss rather than earning profit. Let us say that NM, our investor, bought 10 shares of XYZ Ltd. (spending ₹1000) again, with an expectation of deduction, but this time, the price of shares increased by ₹10. NM will wait for some time with an expectation of deduction but again the share price increases by Rs.10. Hence, the share price of XYZ Ltd. increased by Rs.20 and since NM is obligated to return those shares to the broker within 24 hours, he will purchase those shares for each being Rs.120 (spending ₹1200) and return those shares to the broker, suffering a loss of Rs.200 rather than earning profit.

Shorting is a famous technique often practised by investors in the share market to earn a profit. It takes place after proper research to suggest that the price of shares of a particular company will decrease; however, sometimes a group of other investors, who are against those who perform shorting, start purchasing shares of the stock that is being shorted. When the demand for a particular commodity increases, its prices also increase; hence the price of shares increases and the investors who had taken a short position will now have to buy the shares at a higher price. The longer the wait, the higher the price goes, and in the end, those investors may bear heavy losses.

There is the pertinent question of whether this practice is legal or not. Here is the answer.

A short squeeze is a notorious practise but not necessarily illegal. In most markets, there are no laws against this practice. Nevertheless, it has been subject to temporary bans in several cases. In 2008, the U.S. Securities Exchange Board put a temporary ban on short-selling on shares of hundreds of companies to avoid short squeezing. In India as well, the SEBI (Securities Exchange Board of India) banned short-selling in March 2001 because there were allegations on then-president of the Bombay Stock Exchange, Anand Rathi, of acquiring confidential data from Bombay Stock Exchange. Later, those allegations were removed, and finally, in 2008, this ban on short-selling was taken away.


Reach Out to Us

© 2023 by Train of Thoughts.